ETF closures are not particularly newsworthy in the US: some 48 other funds have called it quits since the beginning of 2011, and there will no doubt be many more as the market evolves. But I think these latest closures are much more significant, and here’s why: these were genuinely good products.

As the ETF market has exploded in the last six or seven years, all manner of exotic, narrowly focused products have sprouted up like weeds. Not only is it unsurprising that many failed to attract investor interest, it’s heartening. It was hard to shed a tear over the demise of the HealthShares family of funds that included ETFs specializing in Dermatology & Wound Care, Metabolic-Endocrine Disorders and Autoimmune-Inflammation. Is it any wonder they pulled the plug on these terminally bad ideas?

Even FocusShares had an earlier line of laughable products that was euthanized in 2008. One held companies in casino, alcohol and cigarette business and called itself the FocusShares ISE SINdex Fund (SINdex, get it?). Another held only suppliers for Wal-Mart. Meanwhile, the list of ETFs that closed earlier this year tracked Taiwanese small-caps and the Russian ruble.

Nice guys finish last

But these latest closures are different. The 15 FocusShares ETFs on the chopping block were based on mainstream Morningstar indexes, and they were all extremely cheap. There was a broad-market U.S. index fund with a management fee of just 0.05%. There were large-cap, mid-cap and small-cap ETFs. And finally there were 11 sector funds, all with fees between 0.12% and 0.19%. To top it off, clients of Scottrade could trade them with zero commissions. As low-cost options go—at least for US stocks—only Vanguard can compete with that.

The Russell ETFs are much more specialized, but we’re hardly talking about Dermatology & Wound Care. The family includes a number of growth, value and momentum ETFs, others that screen for low- and high-beta stocks, and a couple of dividend ETFs. Remember, too, that Russell is one of the best-known index providers in the world, and some $80 billion is invested in funds that track Russell benchmarks. The news that they’ve abandoned the passive investing business is significant.

Lessons learned

What does the demise of these ETF providers mean? First, it suggests the market for mainstream index ETFs is probably saturated in the US. If an investor is simply looking for low-cost, passive exposure with cap-weighted ETFs, they don’t need to look beyond Vanguard, iShares and State Street. This trio controls about 85% of ETF assets, and they’re not likely to give up any of that market share.

Even if a competitor like FocusShares can offer competitive fees, they can never match the economies of scale or the liquidity of the big three. Why buy the Focus Morningstar US Market Index (FMU) with its $20 million in assets and low trading volume when you can buy the Vanguard Total Stock Market (VTI) with $190 billion and 1.5 million shares changing hands every day? To save one basis point in MER?

Second, it’s a reminder that ETF providers can’t be profitable charging low fees on small funds. The 26 Russell ETFs had total assets of about $300 million and an average management fee of 0.33%, which works out to just under $1 million in revenue. That’s just not enough to sustain a business. FocusShares, meanwhile, attracted a mere $100 million in assets, and with an average fee of 0.15% that’s $150,000 in revenue—probably less than what some of the company’s employees earn.

In Canada, Horizons has wound down 10 of its ETFs this year, including four on August 3, though it’s fair to say these were fringe products. So far we haven’t seen any closures of ETFs in major asset classes since late 2005, when TD made the most ill-timed decision in ETF history. I hope it stays that way, since the competition is good for investors. But this month’s casualties in the US are a reminder that the ETF space is a tough arena to do battle.

11 Comments

Andrew F
August 30, 2012 at 11:14 am

Good post.

Thankfully, the barriers to entry are so low for ETFs that even if we end up with a cozy oligopoly of ETF providers for the big vanilla passive indexes, they can’t drive MERs up too much before a new entrant could challenge them (especially one with their own distribution/wealth management operation).

ETFs are definitely something of a winner-take all market, where massive ETFs can gather $100 billion in AUM, and still make a tidy profit on miniscule fees. It’s kind of like Amazon and online retail.

A 5 bps profit margin on $100 billion is $50 million–not too shabby.

Wendy
August 30, 2012 at 12:47 pm

This is to be expected in a young business segment with significant economies of scale.

In 1921 there were nearly 100 firms producing automobiles in North America.

Now, there are… well… fewer.

adam
August 30, 2012 at 3:35 pm

Monopolies usually leave the consumer with a higher price tag on an inferior product.

Wendy
August 30, 2012 at 4:24 pm

The Canadian ETF market is hardly a monopoly.

Even if every player other than Vanguard, iShares and State Street withdrew from the market, we still might actually be better off. (Higher AUM –> Lower Costs)

I can name 30 global automakers that make a vehicle that is essentially identical to a Toyota Corolla. Would we really be better off if there were 300?
I would argue that we might be better off if there were only 3.

Andrew F
August 30, 2012 at 4:53 pm

The US experience with the Big 3 indicates that three companies is not enough to ensure competitive product offerings. American cars were fairly bad until foreign competition forced them to become more efficient and design better cars.

Now, with ETFs, 3 may be the right number. Really, all we need is the credible threat of new ETFs entering. Many index niches only have one or two funds with vast chunk of the assets (like VTI and SPY, or XIU in Canada).

You know, as much as I wouldn’t buy it, there is a kind of logic to the “SINdex” fund. Any time investors behave a certain way for purely ‘behavioural’ reasons, as opposed to making decisions based purely on risk and expected return, there is theoretically an opportunity that exists for “rational” investors who take the other side of the deal. (Rational in this case meaning simply investors who seek to maximize risk-adjusted returns.)

We know that “ethical” investors and funds exist, which seek to avoid these types of products for non-financial reasons. Therefore, their prices should theoretically be artificially deflated, and so they should provide a better investment on average than other stocks. (This is the same as the behavioural explanation for the value premium – presumably some investors prefer exciting, growth stocks over value ones, to a degree not supported by their fundamentals.)

Of course, just because the ethical concerns may not maximize profits doesn’t mean they’re irrelevant*, and even with those aside there are plenty of other market factors at play, so it’s certainly not a sure thing. That said, there is at least a rational reason for a “SINdex” fund to exist, and even to charge a bit of a management premium (exactly like a value fund).

*I personally wouldn’t be comfortable owning a fund like this or individual stock in many of those companies, but it doesn’t stop me buying total-market index funds.

Friday Links
August 31, 2012 at 5:00 am

[…] This week the Canadian Couch Potato revealed the unfortunate fact that More ETFs Close Their Doors. […]

dale
August 31, 2012 at 10:02 am

yes but get ready for Vanguard, more to come from them in Canada for sure. meaning lower fees more competition and perhaps more smaller funds not making it.

The Weekly Lineup: Bonds, Banks, and the Dividend Toolkit | The Dividend Ninja
September 2, 2012 at 10:57 am

[…] So where’s the profit to be made for investment companies offering low-cost indexing ETFs? In the U.S. the smaller players can’t compete and are winding down. What’s in store for the Canadian ETF landscape? Check out the Couch Potato’s recent post, More ETFs Close Their Doors. […]

Mark
March 14, 2013 at 3:10 pm

So where does the share holders money go? Is a portion returned or is it lost to pay the bills for etf company?

@Mark: No shareholder money is lost: this is not like a bankruptcy, or a stock going to zero. When an ETF closes, it makes the announcement weeks in advance and unitholders can choose to sell at their leisure. If they do not sell by the closure date, the shares are redeemed at their current price and the unitholder gets the cash.